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Calming the Terrified Client

Say what you will about mutual fund companies, but one thing they are good at is paying attention to the mood of the investing public. Back in the 1990s when folks wanted to get in on the tech boom, the industry created hundreds of tech funds. Now, as customers crave safety, fund marketers have come up with principal preservation funds that, as the name implies, guarantee that clients won't lose money.

Say what you will about mutual fund companies, but one thing they are good at is paying attention to the mood of the investing public. Back in the 1990s when folks wanted to get in on the tech boom, the industry created hundreds of tech funds. Now, as customers crave safety, fund marketers have come up with principal preservation funds that, as the name implies, guarantee that clients won't lose money.

These vehicles typically promise to return an investor's principal — plus a share of any capital gains. A recent principal protection offering from Salomon Smith Barney collected $900 million in assets, while an ING fund attracted $500 million. Altogether, principal protection mutual funds hold around $3.5 billion in assets, according to Financial Research Corp. And more companies are rushing to enter the field.

Such products are only for the most gun-shy clients. They carry extra fees and have limited upside potential. “Most investors should continue to own a diversified portfolio of conventional stock and bond investments,” advises Kristin Adamonis, a research analyst for FRC. “The principal protection funds may only be appropriate for clients who are terrified of suffering any losses and won't participate in the markets without special guarantees.”

For most clients, however, there are more lucrative options to provide a respectable return without assuming the risk of straight equity funds. Consider, for example, closed-end municipal bond funds. Closed-end funds, obviously, are mutual funds (in that they own a basket of securities), but they trade like individual stocks on the New York Stock Exchange. Like an equity, the value of a share of the closed-end fund moves on investor sentiment; many closed-ends, then, trade at discounts to the value of their portfolios. On the plus side, they can also trade for more than the underlying value of securities. Right now, many funds pay tax-free yields ranging up to 7 percent, the equivalent of a taxable bond paying more than 10 percent for someone in a high bracket.

“I'm buying these funds like crazy,” says Alfred Blomquist, a financial advisor in Franklin Lakes, N.J., who specializes in closed-end funds. “The yields are so high they can compensate for any losses that might occur if the share prices drop.”

Over the years, yields of closed-end municipal funds have often been lower than those of Treasuries. But that has changed. With investors flocking to the safety of Treasuries, their prices have soared, and yields have collapsed; 10-year Treasuries currently pay only 4 percent. Meanwhile, prices of municipal bonds have languished, and their yields have grown relatively fat.

Blomquist is particularly keen on leveraged municipal funds, which boost yields by borrowing in the short-term markets and using the proceeds to buy longer-term bonds. Funds can currently borrow at rates as low as 1.5 percent and invest the money in bonds yielding more than 5 percent. If short-term rates suddenly skyrocket, the strategy could backfire. But skillful portfolio managers have long used leverage to enhance returns without taking needless risks.

A top leveraged performer is Nuveen Quality Income Municipal, which currently yields 6.9 percent and sells for a discount of 6.5 percent to the value of its assets. For the past decade, Nuveen has paid monthly dividends like clockwork, with payments ranging from 7.6 cents per share to 8.7 cents per share. The fund maintains the stability of the dividend by accumulating extra cash in good times and paying some of it out during periods when the dividend would otherwise have to be slashed. Another strong choice is Morgan Stanley Quality Municipal Income, which yields 6.6 percent and sells for a discount of 10.7 percent.

Nuveen portfolio manager William Fitzgerald notes that leveraged funds can suffer significant losses during periods when interest rates rise. Therefore, such vehicles are not for the ultraconservative. “A leveraged fund can give you extra yield, but you need to hold it in a diversified portfolio that includes unleveraged funds and other bonds,” he says.

For clients who crave absolute certainty, the ideal choice may be stable value funds. Long a mainstay of retirement plans, stable choices currently account for 27 percent of the assets in 401(k) plans, up from 14 percent three years ago, according to Hewitt Associates. Several stable value mutual funds have been introduced, including Morley Capital Accumulation and PBHG IRA Capital Preservation. The stable value funds typically own bonds and resemble short-term bond funds. But bond funds can lose money when interest rates rise, and stable value funds are structured so that shareholders never suffer downturns.

Safe Choices
Fund Ticker 1-year return 3-year return 5-year return expense ratio
Closed-end municipal funds
Morgan Stanley Quality* Municipal Income IQI 3.7% 8.0% 5.0% 0.71%
Nuveen Quality* Income Municipal NQU 2.5 6.3 3.2 1.17
PBHG IRA Capital Preservation PBCPX 4.8 6.0 NA 1.25
American Century Inflation-Adjusted ACITX 7.7 10.2 7.1 0.59
PIMCO Real Return Bond A PRTNX 11.9 8.0 11.0 0.90
Vanguard Inflation-Protected Securities VIPSX 12.7 8.9 NA 0.25
Source: Morningstar.
*Returns for closed-end funds through 10/25
All other returns through 10/31.

Shares of stable value funds are held at a fixed price, such as $10. To accomplish this, portfolio managers purchase insurance contracts that cover any losses. Because of the cost of insurance, a stable value fund would be expected to underperform a comparable short-term bond fund by a small amount over the long term. During the past three years, PBHG IRA has returned 6.1 percent annually, lagging the average short-term bond fund by 0.3 percent, but still outclassed money markets by more than 2 percent.

Stable value funds have been popular with investors who are rolling retirement accounts into IRAs. “Most investors are used to the idea of a secure investment, and they want a core fixed-income holding that will not spring any surprises,” says Laura Dagan, portfolio manager of PBHG IRA.

Finally, there is one of the biggest stars of the bear market: inflation-indexed funds. These invest mainly in Treasury Inflation-Protected securities (TIPs), which increase in value along with the consumer price index. During the bull market of the '90s, TIPs attracted little interest. But inflation has been edging higher. With investors racing to protect their nest eggs, inflation funds produced double-digit returns in the past year.

The biggest fund in the category is PIMCO Real Return Bond, which holds corporate and foreign bonds as well as TIPs. Other choices are Vanguard Inflation-Protected Securities and American Century Inflation-Adjusted Bond. Casey Colton, the American Century portfolio manager, has the freedom to hold some conventional Treasuries when he thinks inflation will prove unthreatening. But now he expects inflation to rise, thus his fund holds only TIPs. Colton notes that a 10-year inflation bond would outperform a conventional Treasury during the next decade if annual inflation rates top 1.5 percent. Inflation is currently running at an annual growth rate of more than 2 percent. “If inflation just rises a little, TIPs will prove to be good choices,” he says.

There is little reason to expect that the days of double-digit inflation will return anytime soon. But in times of great uncertainty, advisors with risk-averse investors — and there are plenty of those — should consider instruments that can hold their value.

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